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Get the biggest bang for your buck using the Modern Portfolio Theory (Concept 3)

bang for your buckWe all want the biggest bang for our buck—the more ounce to the bounce, or in other words, better value for money spent. It’s human nature to want the best output for our input, especially when it comes to investing.

Wouldn’t it be great if we were guaranteed the highest investment returns while taking on the lowest risk?

Fortunately, there’s a theory for that. The Modern Portfolio Theory was designed to help investors make their portfolios as efficient as possible. It was developed by Harry Markowitz and Merton Miller at the University of Chicago in 1972, and later expanded by Stanford professor William Sharpe.

In essence, the theory proposes that for every level of risk, there is an optimum combination of investments that will give the highest rate of return. This combination forms the efficient frontier line.

When determining the efficient frontier for my clients’ portfolios, I consider the expected rate of return, standard deviation, and correlation coefficient for each asset class. From here, I design a portfolio with the highest expected return at each incremental level of risk. Sounds easy, right?

Luckily, you don’t have to do this on your own. As a wealth manager, it’s my job to make sure my clients are investing as efficiently as possible. However, that being said, the theory is not as daunting as it seems.

Once you’ve looked into asset allocation discussed in my previous post, the Modern Portfolio Theory involves plotting each investment combination; each plot represents a given level of risk and expected return. The series of points eventually forms the efficient frontier (see above diagram).

Surprisingly, many investor portfolios fall significantly below the efficient frontier, including the TSX Index. It means investors can have either the same rates of return with much less risk, or a higher rate of return for the same level of risk.

See what a little knowledge can do? I recommend checking your portfolio and making sure you’re getting the highest return for your level of risk. Or,my team and I can help make this happen. It’s our job and we love doing it!

Stay tuned for Concept Four: Rebalancing in your quest towards financial success.